Investing in property through a self-managed super fund (SMSF) has grown in popularity in recent years, particularly since it became possible for SMSFs to borrow money to fund a direct property purchase.
This is an area where you really do need to make sure you know what you're getting into. Here is our guide to buying property through your SMSF.
Investing in residential property
Property purchased through an SMSF cannot be lived in by you, any other trustee or anyone related to the trustees - no matter how distant the relationship.
It also cannot be rented by you, any other trustee or anyone related to the trustees. So, buying a holiday home in your SMSF and living there during the summer is not allowed.
Further to this, you cannot put an existing residential investment property you have into an SMSF – either by way of the fund purchasing it at market value, or contributing to it within the cap limits.
Investing in commercial property
Generally speaking, investing in commercial premises through an SMSF has some advantages over residential properties. The rules relating to holding residential property in an SMSF very clearly stipulate that the property can't be rented or occupied by you or any other trustee. It also can't be rented or occupied by any relation to the trustees.
Investors who think they can purchase a holiday house in their SMSF to enjoy over the summer will need to think again; the rules are clear and strict. Investors who already own an existing residential property can't transfer the property into an SMSF by acquiring it at market value or contributing it within the cap limits.
While commercial properties can be sold to an SMSF by its members, as well as being leased to SMSF trustees or an individual or business related to them, there are still a host of considerations.
Holding commercial properties in an SMSF is open to all SMSF trustees, not just small business owners. To purchase a commercial property in an SMSF, a fund may apply for a specific SMSF loan. However, the criteria are stricter than traditional lending with tighter loan to value ratios.
Many small business owners use their SMSF to purchase a business premises and then pay rent direct to the SMSF. It's important to get this right; the rent paid must be at the market rate (no discounts) and must be paid promptly and in full at each due date.
The investment must also satisfy the overarching function of the SMSF, which is to provide retirement benefits for its members (this concept is known as the sole purpose test).
Using your SMSF to purchase premises may make sense for your business. However, to comply with the regulations, you must ensure the purchase provides a retirement benefit for the trustees.
Consider the yield and expected growth in property value. If the property dsn't shape up, you may need to reconsider.
The tax consequences of buying and renting property
If you buy a property through an SMSF, the fund is required to pay 15% tax on rental income from the property. On properties held for longer than 12 months, the fund receives a one third discount on any capital gain it makes upon sale, bringing any capital gains tax liability down to 10%.
If the property is purchased via a loan, the interest payments are tax deductible to the fund. If expenses exceed income there is a taxable loss that is carried forward each year and can be offset on future taxable income.
Once trustees start receiving a pension at retirement, any rental income or capital gains arising in the fund will be tax free.
Note also, that if you make a loss on your property, any tax losses cannot be offset against your personal taxable income outside the fund.
Commercial Cans and Can'ts
Rent is often considered dead money. Given that commercial property purchased through an SMSF can be leased back to the trustees, it makes sense that many choose to pay off their asset, and not a landlord's.
When investing in commercial real estate, SMSF funds have the option of investing 100% into commercial premises if a member of the fund runs a business. This is an attractive proposition for small businesses who want to own the premises from which they operate. Investors or businesses which already own a commercial property can contribute the property to the SMSF. The transaction will have to be at market value and is subject to the contribution caps. Keep in mind that transferring property may have capital gains, stamp duty and tax implications, so always get advice before making concrete plans.
When it comes to leasing the property to a related party, it must be done on the same terms as it would with an independent third party. If you were leasing to an independent third party, a lease arrangement needs to be in place, clearly outlining the terms and conditions of standard commercial agreements. Market rate rent will need to be paid regularly and physically into the SMSF bank, and the property will need to be periodically independently valued.
Borrowing to buy property in your SMSF
Borrowing to buy property through an SMSF is achieved through a limited recourse borrowing arrangement (LRBA).
To 'limit the recourse' of the lender, a separate property trust and trustee is established to hold the property on behalf of the super fund, outside the actual SMSF structure. All the income and expenses of the property go through the super fund's bank account. The super fund must meet all loan repayments. If the super fund fails to do this, the lender only has the property held in the separate trust as recourse, and cannot access any remaining assets of the super fund.
Borrowing criteria for SMSFs
Borrowing criteria for an SMSF is generally much stricter than a normal property loan that you might take out as an individual. The loan also comes with higher costs, which needs to be factored in when working out if the investment is worthwhile.
Currently the general consensus is that most financial institutions will not consider lending to an SMSF unless they have a balance of at least $200,000.
If your primary purpose for wanting to have an SMSF is to purchase property with a mortgage then consulting with a bank or mortgage broker is strongly recommended before you even establish the super fund, to identify if you have sufficient funds to obtain finance.
Remember that loan repayments must be made from your SMSF. This means your SMSF must always have funds available to meet the loan repayments. The SMSF can fund the loan repayments through rental income on the property and through superannuation contributions into the fund.
SMSFs need to value all of their assets at market value, and the valuation needs to be based on objective and verifiable data. If an SMSF holds commercial property, a real estate agent or registered valuer will need to provide an independent valuation.
If the commercial property produces a gross rental income in excess of $75,000 per annum, the fund will also need to register for GST. Once the SMSF is registered for GST, it can claim 100% of GST on any expenses associated with the commercial property.
Once the property begins to produce a rental income, it will be taxed at 15%. If the property is sold (after owning it for more than 12 months), 10% capital gains tax will apply. If the SMSF is in pension phase and the sale fits within the member's $1.6m balance cap, then no capital gains tax is payable.
Given its appeal for small business owners, commercial property continues to make a compelling case from a tax planning and long-term capital growth perspective. However, with all investments, there's a flip side. Issues such as lack of investment diversity and liquidity considerations of holding one 'lumpy asset' needs to be weighed up when choosing commercial property for your SMSF.
You are responsible for compliance
The ability to purchase property in your SMSF with borrowings comes with some very strict rules and obligations that you may not be familiar with as they are not requirements that exist outside an SMSF.
It is very common for trustees to inadvertently breach these rules, as many trustees are not aware of the rules until their fund is audited.
It is up to you as a trustee to make yourself familiar with what you can and can't do, as the ATO will hold you responsible.
There can often be expensive repercussions for not quite getting it right – from trustee penalties issued by the ATO to stamp duty implications.
All trustees are personally liable for any decisions made by the fund, even if they engage a third party to assist, or another member/trustee makes a decision. It is therefore really important to engage experienced, qualified specialists to assist you when taking on the role of managing your own retirement savings.
Purchase the property in the correct name
The property must be purchased and held in the name of the trustee of the bare trust. Many people purchase the property first and then subsequently set up their SMSF and associated legal entities to arrange finance for settlement of the property. Failure to purchase the property in the correct name may lead to expensive stamp duty implications.
Renovating your property
Simple insignificant repairs and maintenance to the property can be paid for from borrowed monies. If you wish to do significant improvements or renovations to the property, this is allowed but must be funded by available cash already held within the super fund and not by the loan or borrowed money.
You are not allowed to make significant changes to the original asset that was purchased using the limited recourse borrowing arrangement. Renovations that substantially change the asset will require a new limited recourse borrowing arrangement.
Single acquirable asset
The concept of 'a single acquirable asset' is very important when dealing with a limited recourse borrowing arrangement (LRBA). The basic premise is, if the property runs over multiple titles, each title will require its own bare trust, trustee and LRBA.
The ATO has clarified certain scenarios that it is permissible to have just one LRBA, and where multiple LRBAs would be required.
Single LRBA is required in these scenarios:
Factory complex that runs over multiple titles and therefore cannot separately sell titles
House and land package
Completed 'off the plan' property – if cash paid for the deposit, an LRBA can be used to pay balance
Apartment with separate car parking space – although separate titles you can't sell one without other, so one LRBA is ok
Option to purchase a house (just the option) – if the house is then purchased, this must be done with separate arrangement as a different asset to the option.
Multiple LRBAs required in these scenarios:
If the vendor will only sell the two titles together (but it is legally permissible to sell them separately)
Farmland with multiple titles – if no legal impediment to selling them separately
A block of land purchased – at a later date it is decided a house is to be built on block
A serviced apartment that is fully furnished – the apartment and furniture are seen as two separate assets.
Fees and charges when purchasing property
There can be substantial fees and charges associated with the purchase, ownership and subsequent sale of a property in an SMSF. These will eat into your super balance so you need to ensure the income in the super fund will cover these costs and allow for growth.
Many people assume that if they contribute personal money into the purchase, that once the super fund has the money, they can repay themselves. This is not the case. You may contribute your own money to help purchase the property, but this is considered a personal contribution to your super fund and cannot be withdrawn until you meet preservation age.
H&R BLOCK SMSF SOLUTIONS
Depending on your financial situation, a self-managed super fund (SMSF) can give you more control over your superannuation and retirement. With complicated rules and strict governance in place, those looking at investing in commercial property through their SMSF should always seek qualified and experienced advice.
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